A Dour View From the State Level

 | Aug 30, 2011 | 6:57 AM EDT
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While federal spending receives quite a bit of press, state governments (when including education) actually employ more than twice as many people as does the federal government (excluding the postal service, which is self-supporting). Even without educational institutions, such as state universities, state government payrolls are a more important part of the economy since they employ 2.7 million people vs. 2.2 million people at the federal level. Also, many services that the states provide are more directly felt by residents of those states rather than federal spending, which might perhaps go to an area such as defense spending.

Regardless of one's opinion about government, public sector employees receive paychecks and spend money in their local community. The local hardware store does not keep a separate cash register for government employees' cash and one for cash of private-sector employees. Since states cannot "print" money and most cannot engage in deficit spending, as does the federal government, we might expect state governments to continue to be a drag on the economy since they must cut spending and/or raise taxes. Neither option will help economic growth.

Since total nonfarm employment hit its low point in February 2010, payrolls of private employers grew by 2.2%, while state payrolls (excluding education), fell 3.8%, and state employment is off by 5.3% from its peak. Add to these decreases the data from local governments, some of which depend on assistance from the state for their budgets, and state and local employment has dropped by 539,000 since August 2008. The state and local governments have subtracted between 0.33 and 0.41 percentage points from GDP in each of the past three quarters, when the rest of the economy has been recovering, albeit slowly.

This drag may continue into the future. Recently, the Chicago Fed researched the issue, and illustrated the varied nature the problems in different states, which likely require different solutions, but the end result is generally the same. Some combination of fewer services, more layoffs and higher taxes -- each of which will tend to depress economic growth -- is being considered as the way to deal with the states' problems. However, one key point is that "states currently face a revenue and spending crisis, not a debt crisis," comments Gail Sussman of Moody's. As such, we should be very cautious about applying parallels between state government issues and those of the federal governments.

A general theme that crosses state problems seems to be that politicians overpromise, don't understand economics and their planning defies the law of the business cycle by simply assuming good times would last into perpetuity. They don't and they didn't.

For example, the Chicago Fed paper cites Laurence Msall of the Civic Federation in Illinois as describing its well-publicized woes as poor budgeting practices and a lack of preparation for dealing with the economic downturn. The result is that the budgets for fiscal 2009, 2010 and 2011 were "balanced" through pension borrowing, delaying bill payments and fiscal gimmicks. As a result, its pension is only 45% funded -- the worst in the nation. Even with recent tax hikes, Illinois's budget still conceals hidden liabilities, such as a backlog of unpaid bills that approached $4.6 billion, as the research notes, even though it is "balanced" on paper.

Wisconsin, a neighboring state, had simply extrapolated the good years of the 1990s and overcommitted to spending, while cutting taxes over much of the past decade with "15 years of structural imbalance." It avoided "fiscal calamity" only by $2.2 billion from federal stimulus aid, the Chicago Fed notes. The state currently faces a $3.6 billion budget gap that needs to be addressed. It is responding by cutting employee benefits and ending collective bargaining, among other things, such as cutbacks in both primary and higher education funding.

New York, on the other hand, was too dependent on income taxes from higher wage earners, and when Wall Street slashed payrolls and bonuses, the lack of revenue diversification caused an estimated budget gap of $10 billion. The state responded by hiking income taxes even more on higher wage earners for three years, along with other temporary tax increases, and cutting Medicaid and school aid.

Since it is extraordinarily difficult (and may even be legally impossible) for a state to declare bankruptcy, eventually the challenges facing many states will continue to be a drag on the economy as spending is cut and/or taxes are raised.

However, spending in some areas, such as education and infrastructure, are investments in the future. Education spending seems to be a popular target for cuts, as are other basics, such as health care spending and highway maintenance. Having a well-educated, healthy workforce and well-paved, functioning roads, however, are essential ingredients in a business's decision to establish a facility in a given locale. Short-changing these types of investments might make a bad situation worse for years to come.

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